Prohibited activities and penalties

No list of prohibited activities can be complete, because dishonest people keep inventing new ones.

The major categories of prohibited activities under FINRA rules are listed below. Several are covered in more detail in this chapter or elsewhere in the course.

• Manipulative and deceptive practices: No person involved in the industry can use manipulative, deceptive, or fraudulent practices, or use any form of market manipulation. Market manipulation is covered below.
• Insider trading is the use of non-public material information to buy or sell stock, or simply being in the possession of said information, and conducting a transaction in the security. We go into more detail in another section on insider trading.
• Recommendations must meet the required standard: Regulation Best Interest for retail customers (natural persons who use the recommendation primarily for personal, family, or household purposes), and FINRA’s suitability rule (Rule 2111) where Reg BI doesn’t apply, such as recommendations to institutional customers. This is why we have to strive for as full and complete customer identification information as possible.
• Misleading communications: We cannot communicate false, exaggerated, or promissory claims in communications. We must follow the communications rules and filing requirements.
• Borrowing or lending money with a customer is generally prohibited under FINRA Rule 3240, unless one of a short list of exceptions applies: the customer is in the business of lending money (such as a bank); the customer is an immediate family member; the registered person and customer have a bona fide, close personal relationship that was formed before the broker-customer relationship and is maintained outside of it; the registered person and customer have a bona fide business relationship that exists outside the broker-customer relationship; or both are registered persons at the same firm. Even then, the firm must have written procedures allowing it, and for the personal relationship, business relationship, and same-firm exceptions, the registered person must notify the firm in advance and get its written pre-approval. Individual firms may also impose their own, stricter rules.
• A representative selling away. That is participating in a private securities transaction without giving the firm the required written notice, or, when the rep is compensated, without the firm’s written approval or after being denied it.
• Front running (FINRA Rule 5270), covered under Market manipulation below.

When a question asks which activity is not prohibited, three of the choices are, and it can be easier to rule those out first.

Market manipulation

Market manipulation refers to prohibited activities that artificially change the price and/or volume of a security. The list below covers the most commonly tested market manipulation practices. Arbitrage is not one of them. It is buying a security in one market and selling the same security, or one it converts into, in another market at nearly the same time, to profit from a difference in price. The price difference is real and nothing is made to look like something it isn’t, so arbitrage is a permitted practice.

Painting the tape - Painting the tape is entering a series of transactions, often between cooperating traders, that print on the tape to create a false appearance of active trading or of a rising or falling price, to lure other investors in.

Wash trade/matched orders - Both create a false appearance of trading. A wash trade is a transaction with no change of beneficial ownership: the same person is on both sides. Matched orders are a buy and a sell of about the same size, at about the same time and price, entered by parties who each know of the other’s order. If someone buys and sells 1 million shares of the same security, at the same time, that doesn’t really cost them anything, other than potentially sales commissions, but it does make it look like a large increase in volume, which could drive up demand.

There can be some easy confusions with similar words. Wash sale is a different concept than wash trade. A wash sale occurs when you sell a security at a loss and then buy the same or a substantially identical security within 30 days before or after the sale date - a 61-day window in total. The loss is disallowed for tax purposes; the transaction itself isn’t unethical or illegal. The disallowed loss isn’t gone for good, though: it is added to the cost basis of the replacement shares, so it is deferred until those shares are sold. Matching orders is equally quite different from matched orders. Matching orders is simply the process of finding someone who wants to buy what someone else wants to sell. If someone wants to sell 1,000 shares of ABC, and another client places an order around the same time to buy 1,000 shares of ABC, those orders match, and the transaction commences.

Bear raids - Bear raids refer to attempts to move the price of a stock down by selling large numbers of shares short, and then pocketing the difference between the initial price and the new, lower price. Massive increases in short selling can drive a stock’s price down artificially. The SEC addresses this through Regulation SHO’s Rule 201, the alternative uptick rule: once a security’s price drops 10% or more in a day, short sales in that security are restricted to prices above the current national best bid for the rest of that day and the next trading day.

Spoofing and layering - These are manipulations usually used by high-frequency traders. Spoofing is placing bids or offers with the intent to cancel before execution. Layering is a form of spoofing where the trader places multiple orders on one side of the book in order to create false impressions of heavy buying or selling, a false impression of volume.

Marking the open/close - Two related manipulative actions, basically trying to affect the “closed at” price, or the “opened at” price of a security to benefit the person committing the manipulative action. Marking the close would be buying or selling very near the end of the day, to help drive the market up or down, in order to get the “market closed at” price to reflect a benefit to them, and not reality. Marking the open is similar, just trying to get the first price of the day. Marking the close is a much more common manipulative practice.

Frontrunning (FINRA Rule 5270) - Frontrunning, or front running, appears to be closely related to insider trading, in that insiders at the firm have information that will affect a security’s price. Unlike insider trading, where the information could be a merger, or an investigation, or a failed test, or anything personally related to the industry or company, frontrunning is more about market effects. The firm would buy or sell a large amount of stock before putting in a client’s order in that same security. When they place the even larger, generally institutional, client order, they know that the larger order will affect the price of the stock, and therefore they benefit when the price moves in the direction they bet on.

Trading in advance of a research report (FINRA Rule 5280) - Similar in regards to frontrunning, trading in advance of research reports can also be thought of as similar to insider trading. This time though, it isn’t confidential information about the business or industry events, and it isn’t about knowledge of institutional orders that will affect the price. In trading ahead of research reports, also sometimes simply referred to as trading ahead, research analysts at our firm have compiled a new report that is going out next week. It has either extremely positive, or negative, findings about the company, so we know it likely will raise or lower the price due to the inherent recommendation. So someone with knowledge of this report goes and buys or sells securities before it is publicly available.

Firms have tried to argue that when they are about to publish a research report that is positive, their purchasing of shares is to help make sure they have the inventory for anticipated customer purchase requests. Regulators do not accept this. FINRA rules state that member firms may not establish, increase, decrease, or liquidate any inventory position, based on knowledge derived from advanced knowledge of research reports.

This is also the reason that member firms are required to establish, maintain, and enforce policies to prevent research reports from going between research and trading departments (information barriers), and to monitor research analysts themselves.

Collusion - Collusion is when traders, brokers, or market makers secretly work together to profit at the expense of the general public. Investigations and enforcement actions illustrate why these rules matter. To avoid collusive activities or behaviors, traders must avoid;

• Communicating with different firms where prices are not set independently.
• Communicating with other traders to manipulate prices; getting them to move quotes in a direction, change their quotes, delay transaction reporting, or even misreport transactions on purpose (error accounts exist for accidents, not purposeful manipulation).
• Making statements that could be seen as extortionate, threatening, harassing, or anything similar.
• Providing information they shouldn’t such as customer orders or strategies, market makers orders, strategy, non-public research, upcoming quotes, or similar internal details.
• Backing away or claiming they plan to.

Sanctions for violations of the rules

There are 2 primary types of “negative” actions that can be applied. We need to be a bit careful, because one of them isn’t really a negative; they aren’t actually penalties, even if they sort of feel and sound that way.

The 2 types of actions could be punitive or non-punitive.

Punitive

Punitive means it actually is a negative, these are the punishments that can be doled out.

Censure

Censure is the lowest level of punitive sanction - a formal, official reprimand. It becomes part of the registered person’s permanent record and is typically paired with a fine. Censures are generally reserved for relatively minor violations.

Fines

Fines are monetary penalties, often combined with a censure or another sanction. It’s rare for a punishment not to include a fine.

Suspension/Revocation

Suspension and revocation both take away a person’s registration: a suspension lasts for a definite period, or until the person does a particular act, while a revocation ends the registration. While suspended or revoked, a person cannot act in a registered capacity, and no new commissions can be earned. Once a suspension ends, the person can return. Commissions that accrued before the sanction took effect can still be paid, unless they relate to the activity behind the sanction.

Expulsion

Expulsion removes a member firm from the SRO entirely. SROs are membership organizations, so they have the authority to remove members. FINRA’s Sanction Guidelines recommend suspensions of no more than two years; misconduct serious enough to merit a longer suspension generally calls for a bar (for an individual) or expulsion (for a firm) instead. Expulsion is a firm’s counterpart to an individual’s bar.

Barring

Barring is one of the most severe penalties that can be issued. It removes the person’s registration and explicitly prohibits them from ever returning to the industry. BrokerCheck maintains a public record of individuals who have been barred.

Cease & desist

Telling the rep to stop doing what they are doing. It isn’t so much a penalty, but if not followed, would easily lead to one.

Non-punitive

If punitive is actually a punishment, non-punitive are not punishments. They might sound, or seem like it, but they aren’t.

Denial

Denial simply means the licensee isn’t allowed to proceed - for example, a registration application is denied. It isn’t a punishment, and is often the result of a clerical or procedural issue that can be corrected over time. It can still show on the record: a regulator’s order denying a registration or license is disclosed on Form U4 and appears on BrokerCheck.

Cancellation

A representative can become unable to use their license for reasons unrelated to misconduct - for example, if they die, fall into a prolonged coma or similarly non-functioning state, or cannot be located for an extended period and are presumed missing. In these cases, the license is canceled rather than revoked. If the person later turns up, nothing stops them from reapplying.